Microfinance is increasingly being touted as a miracle cure for poverty. If it is, why isn't it more widespread, and how can it be extended? Although microfinance has been around in various forms for thousands of years, its modern incarnation is most closely tied to Mohammed Yunus, the Grameen Bank founder. In his autobiography, he described how, as a professor in Bangladesh, he came to understand the importance of finance for the poor. Horrified by the consequences of a recent famine, he left the sheltered walls of the university to find out how the poor made a living.

In a neighboring village, he struck up a conversation with a young mother making bamboo stools. He learned that she needed 22 cents to buy the raw material for the stools. Because the young mother didn't have money, she borrowed it from an intermediary, to whom she was forced to sell the stools as repayment. She made a profit of only 2 cents. Yunus was appalled: finance would enable her to sell directly to customers. But the intermediary wouldn't offer her finance, for then he would lose his hold over her. For want of 22 cents, the woman's labor was captive.

In this vignette, many see the worst evil of capitalism: exploitation of labor by capital. But this situation couldn't be further from the essence of free market capitalism: free access and competitive markets. It's the lack of access to a competitive financial market or to a friendly financial institution where the poor can borrow at a reasonable rate that keeps their labor captive.

Poor credit rating

So why don't the poor have access to finance—loans, savings accounts, cash withdrawals, and insurance? Let's dispense with one explanation immediately: active discrimination against the poor. In a world hungry for profits, it's hard to imagine financial firms forgoing any customers. But passive discrimination may be one explanation: when a financial institution caters to the middle class, it may exclude the poor. Some slum dwellers in Chennai told me they felt uncomfortable entering a bank; they were awed by the better-educated and better-dressed bank clerk. Social distance may matter. A study by the Federal Reserve Bank of Chicago found that minority households, alike in all ways but race, were turned down for credit more often than others. A more detailed investigation revealed that loan officers were less likely to help minority applicants overcome problems with their applications. Without intending to discriminate, the loan officers ended up doing just that.

There are other forms of distance. The poor may have no one in their social network (and thus no one they trust) who knows the various financial transactions available. As a result, they may not know enough to choose wisely. Given the small volume of transactions the poor are likely to undertake, the financial provider may not think it worthwhile to educate them even if the gulf of distrust that initially separates the two parties could be narrowed.

Finally, to the extent that bricks and mortar are involved, it makes far more sense for a profit-minded bank to set up shop in a richer neighborhood, where there is more business, than in a poorer one. Given the physical distance between where the poor live and where the bank is located, the poor may simply not have access to financial services. This is a chicken-and-egg problem. If bank branches were more welcoming, more poor people would use them, the branches could profitably be located nearer the poor, and the presence of poor customers in the branches would encourage other poor people to use them.

As for lack of access to credit, common explanations are that the poor aren't creditworthy because they're untrustworthy, they don't have business opportunities or steady jobs, they have little collateral, and, given the small size of the transactions they are likely to make, the transaction costs are too high. On closer examination, some of these explanations are questionable. There is no reason why the poor should be intrinsically more untrustworthy than their richer brethren. And studies show that the poor are more likely to be charitable than the rich.

Also, the poor's lack of access to services means that, at the very least, there are profitable opportunities for those who can get loans and establish themselves as intermediaries. Many have heard of the Bangladeshi villager who borrows money to buy a cell phone and then pays off the loan by charging other villagers to use it. Besides intermediation, all manner of self-employment—sewing, delivering small items, making handicrafts—could be facilitated with a small amount of capital for a sewing machine, a bicycle, or tools. The poor are no different from other small entrepreneurs in that managerial advice and access to business networks can make the difference between success and failure.

But I shouldn't minimize two problems. First, the poor have little legal collateral. But a lack of collateral doesn't seem to be a binding constraint for the middle class in many developing countries, who can borrow against their future salaries or the asset they are buying, such as a car or a house. The greater problem, I think, is that it's harder to keep track of the income the poor generate (unlike middle-class salaries, which are typically paid by established organizations) or the small assets they seek to buy, such as a bicycle.

Second, it's costly for financial institutions to deal with the poor. Accepting a $1 deposit costs as much as accepting one of $1,000. It thus makes sense to allow financial institutions to charge the poor higher rates. But governments often impose "usury" ceilings on the rates financial institutions can charge, shutting out the very people these laws are ostensibly meant to help.

The rise of microfinance

The microfinance revolution recognizes many of these problems and attempts to overcome them in innovative ways. Distance is overcome, typically, by the financier's going to the poor instead of obliging the poor to come to the financier. Loan officers often aren't far removed in social status and wealth from their customers. Also, the microcredit process is as much about education as about finance. For instance, one way to enable the poor to build a support network while giving them social collateral is to involve them in group lending schemes. The first member of a group gets a loan, but the second member must wait until a substantial portion of the first member's loan is repaid. Peer pressure ensures that the loan is repaid, and many microcredit organizations demonstrate extraordinary repayment rates.

Has the microcredit revolution succeeded in its goals? Clearly, more poor people have access to finance. What is less clear is the extent of subsidy involved in extending this access to them. Group lending is very cost intensive and involves the time of both the loan officer and the group. If group lending involves subsidies, is that the best way to spend those subsidies? Also, nontraditional microfinance tends to distance participants from the more formal financial system. This isn't a problem unless the microfinance system doesn't grow fast enough and can't transfer successful participants to the formal system.

How can microfinance be made more viable? Asking this question relegates financial services for the poor to a separate and unequal existence. Instead, we should ask how we can make financial services available to all. If we focus just on finance for the very poor, the thinking immediately shifts to subsidies and charity, which hurts the quality of service. Not only do the poor lack the collective voice to demand better services, but government money can spoil the credit culture. As one participant in a women's credit cooperative said, "We don't default now because we would be defaulting on our sisters' money. If we took money from the government, default rates would go up because we would all feel we were defaulting only on the government."

Financing for all

In truth, in many poor countries, the middle class also has limited access to finance. The same mechanisms that will expand their access will often expand access for the very poor as well. By defining the problem more broadly to include the middle class, we can enlist a powerful supporter in the common fight for access. In the process, the links between the formal and informal financial systems will strengthen, allowing the poor to migrate upward.

What needs to be done? For one, the government should encourage the creation of infrastructure that can allow technology to bring down transaction costs. Giving every individual a national identification number and creating credit registries where lenders share information about their clients' repayment records can be enormously valuable. All borrowers would then have an asset—their future access to credit—that they implicitly offer as collateral when they obtain a loan. The government should also reduce the costs of registering or repossessing collateral, as well as eliminate usury laws. Recognizing, though, that the poor can fall prey to unscrupulous operators, the government should improve consumer protection laws and services.

Perhaps most important, the government should encourage competition in the financial sector. As private sector banks find their traditional businesses coming under fierce competition, they will seek out nontraditional businesses, including providing services to the very poor. Given the right environment, the private sector has the ability, the incentives, and the resources to develop innovative services for the poor. A number of banks around the world, including Citibank, ICICI Bank, and ING, have started doing precisely this.

In sum, then, let's not kill the microfinance movement with kindness. If we want it to become more than a fad, a temporary cause for the glitterati, it has to follow the clear and unsentimental path of adding value and making money. On that path lies the possibility of a true, and large-scale, escape from poverty.

Raghuram Rajan is Economic Counsellor and Director of the IMF's Research Department..